One of the distinguishing characteristics of human beings from other species is our ability to think and plan ahead. Nevertheless, most people have great trouble preparing for long term future events such as retirement. Thinking and acting on thoughts in advance are keys to preparing for the future when it turns inexorably into the present. The younger a person is, the more time he or she has to plan for retirement. In addition, earlier planning and investing provides an individual with more flexibility and a greater probability of an increased “nest egg” because many investments provide compound returns over time.
Most individuals work at least 40 years with the goal of retiring at approximately 65. After retiring, a typical individual utilizes a predetermined percentage of his or her accumulated assets each year to maintain the lifestyle to which he or she is accustomed. The individual may no longer work to increase the sum total of assets, in which case the individual's income sources are limited to investments, employer's pensions, and government support, if applicable. Furthermore, individuals in their later years can be subject to substantial health care expenses, with the potential of nursing home or assisted living confinement being the most prominent cause for concern. In addition, the average life expectancy is currently approximately 85, and has increased significantly over the last 10 years. As a result of all of these factors, there is a substantial risk that an individual may expend the sum total of his or her accumulated assets before passing away, leaving the individual without independent financial support. This risk, known as “longevity risk,” is especially difficult to plan for because of the variety of factors which contribute to it.
Accordingly, retirement planning consists of more than picking an age to retire and a beachfront property on which to retire. In stark contrast, retirement planning requires analysis of an individual's lifestyle, resources, health, marital status, retirement benefits (e.g., health insurance, pensions, etc.) and a myriad of factors that are often taken for granted while an individual is working. Most, but not all such factors, relate to financial issues.
For example, most experts agree that an individual needs about 60% to 85% of his or her current gross household income to sustain a similar lifestyle during his or her post-retirement years. In theory, individuals having a higher current income are closer to the lower end of that scale. In short, current retirement income should approximately equal the individual's gross income less savings and applicable taxes. However, it is widely understood that predicting retirement income is not an easy task. In general, the process of determining an individual's retirement income entails the steps of: (1) deciding on the desired annual income in today's dollars over a period of thirty years or more; (2) establishing a retirement date; (3) contemplating additional, unexpected lifestyle changes; (4) determining a lifetime average inflation rate; (5) determining the average rate of return on investments before and after retirement; and (6) determining the current market value of all current investments (e.g., regular accounts, IRAs, and company tax-deferred savings plans like 401(k) plans). However, many of the variables associated with the above analysis, such as inflation, spending habits, and investment rate of return, are difficult or impossible to predict. In addition, other variables such as the probability of increased expenses due to health problems are nearly impossible to predict. As a result, planning for retirement is extremely difficult and is an inexact science at least.
There have been several attempts to alleviate the difficulties associated with retirement planning and more specifically, to mitigate longevity risk. For example, one simple commonly known method is investing at an early age. For example, if an individual puts $1,000 per year for 25 years into an investment earning 10% annually, the investment will be worth $108,182 after 25 years. Comparatively, by starting that same investment five years later, the net worth of the investment of that same $1,000 per year is only $63,002. However, many people are either not motivated or not financially able to invest early. In addition, there is no guarantee that an investment will yield a net positive return. Finally, although this method allows an individual to accumulate more wealth before retiring, thus putting him or her in a better position, it does not address the situation where an individual lives longer than his or her expected lifespan. As a result, merely planning for retirement earlier is largely ineffective at reducing longevity risk.
Another well-known tool sometimes used to reduce longevity risk is the use of employer retirement plans. Many mid-size and large employers offer various retirement plans to their employees. Indeed, many have two or more. There are several types of retirement plans.
With respect to one such retirement plan, a “defined benefit plan” or a “company pension,” employers typically fund a pension account without any financial contributions from the employees. An employee's final benefit (i.e., payment upon retiring) is determined by a formula often based on years of service, an average wage, and a percent of pay. For example, the plan could set a final benefit of a “joint and 50% annuity calculated as 1.5% times years of credited service times the average of an individual's last three years' base annual wage.” With 30 years of service, at retirement a pension can replace roughly 45% of an individual's final annual wage.
However, increasingly defined benefit plans are no longer being provided by many employers. This is part of a long-term trend, which virtually all experts agree will continue, and may even accelerate. As a result, defined benefit plans are either unavailable, or, when available, do not provide income levels that adequately alleviate longevity risk.
Another type of investment plan typically offered by employers, a “defined contribution plan,” provides an individual account for each participant. The benefits (i.e., the amounts available to the employee in retirement) are based on the amount of funds contributed to the individual's account and are affected by such factors as income, expenses, and investment returns. Some examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans and profit sharing plans.
Often, an employer will make contributions to an employee's account in addition to an individual's contribution. While these contributions vary by employer, employers typically match an individual's contribution from 50% to 100% up to 6% of an individual's pay. In short, if an individual contributes 6% of his or her paycheck to the retirement account, an employer contributes between 3% and 6% as well. While defined contribution plans have certain advantages, defined contribution plans place virtually all of the investment risk on the employee and typically provide no efficient means of converting the accumulated assets into an income stream. As a result, defined contribution plans are largely ineffective as a vehicle for reducing longevity risk.
Another commonly utilized retirement planning vehicle is known as an Individual Retirement Account (“IRA”). An IRA is tax-deferred, so the current tax burdens on an individual are greatly reduced. Once an individual has deposited funds into an IRA, it is subject to IRA rules. A typical IRA, for purposes of this discussion, functions largely as an individual defined contribution plan, but without any employer support. A traditional IRA suffers from all of the deficiencies of a defined contribution plan, when evaluated with respect to longevity risk. Another problem with the IRA is that it limits the contribution amount, which provides less income over time.
Further, it is well known that government subsidized programs exist which alleviate longevity risk. Social Security is one well known example. The Social Security system purports to provide three things: income at retirement, income for survivors, and disability income. Generally, to qualify for full benefits an individual needs to work at least ten years, while contributing a percentage of his or her wages to the Social Security fund. The size of an individual's benefit at retirement is based on earnings and the number of years an individual has paid into the system. An individual may receive retirement benefits on or after age 62. A spouse and, in some cases, dependent children may also receive a benefit.
However, the system was designed to provide for minimum income needs during retirement, and not to provide for all of an individual's income needs. Social Security benefits were designed to supplement an individual's own savings to allow the individual to maintain his or her desired living standard. In addition, it is expected that that the Social Security system will provide future recipients less than it does today, if anything at all. Therefore, although the Social Security system is designed to continue to provide funds to retired individuals even if they live longer than their life expectancy, it is an imperfect system at best for reducing longevity risk.
Finally, the simplest method for mitigating longevity risk is to accumulate a large amount of assets comprised of a diversified portfolio of assets. Then, when an individual retires, he or she simply withdraws a predetermined amount of his or her assets to compensate for any deficiency between the individual's guaranteed income (e.g., defined benefit plans and social security) and his or her lifestyle. This practice, which is currently the most widely used practice, is known as taking systematic withdrawals. However, there are three principal problems with merely taking systematic withdrawals. First, it is impossible to predict an individual's lifespan. As a result, the amount (as a percentage of total assets-withdrawn) may be too high, leaving an individual with no asset to draw down from. Alternatively, the individual may be too conservative, withdrawing too little of an amount, compromising his or her lifestyle. In addition, an individual may simply have an insufficient asset pool to draw from. Finally, systematic withdraws do not account for any volatility associated with the asset pool from which the funds are withdrawn. Accordingly, merely taking systematic withdrawals is insufficient for mitigating against longevity risk.
Because current retirement plans and programs have limited success in mitigating longevity risk, there is a clear need in the art for a system and method to more effectively manage the risk associated with outliving one's accumulated assets. The present invention overcomes the various deficiencies associated with traditional longevity risk management techniques by creating a novel system and method that allows an individual to eliminate longevity risk by purchasing longevity insurance.